No Heat for This Oil Merger

April 05, 2005

By Christopher Palmeri ChevronTexaco's (CVX) annual conference for analysts and investors last December turned out to be something of snoozefest. Sure, thanks to high oil prices, the company was on its way to reporting record earnings of $13 billion for the year. But Chairman and CEO David O'Reilly had no big news for the crowd, no major announcements of new fields, just continued declines in old ones. When a number of attendees started walking out, he ended the meeting early.

Now, O'Reilly is giving Wall Street something to pay attention to. On Apr. 4, ChevronTexaco announced the largest oil-patch merger in years, an $18.4 billion buyout of Unocal (UCL). But rather that greeting the deal with a round of applause, Wall Street is walking out again, this time with its money. ChevronTexaco's stock fell $2, or 3.5%, on the day the deal was announced. It's down 8% since the company was first rumored to be interested in Unocal in early March.

HEADING LOWER? One concern is that O'Reilly may have overpaid for Unocal at the top of the market. An even greater fear among some analysts is that ChevronTexaco -- and perhaps others in the oil patch -- are shifting their focus from return on capital to growth in oil and gas production.

That's chilling to energy investors because it may result in oil prices heading down after a five-year bull market. Prices briefly touched a record $58 a barrel the day of ChevronTexaco's announcement. They've drifted lower to $56 since, in part due to the soothing words Federal Reserve Chairman Alan Greenspan gave petroleum refiners in a speech on Apr. 5. "The same price signals that are so critical for balancing energy supply and demand in the short run, also signal profit opportunities for long-term supply expansion," Greenspan said.

O'Reilly's purchase of Unocal is definitely aimed at expanding production. Chevron's $45 billion acquisition of Texaco four years ago was billed as a way to pursue new initiatives around the globe. Instead, investors watched ChevronTexaco's oil and gas production slide 7%, to 2.5 million barrels per day,, as fields in the U.S. continued their rapid decline and O'Reilly pursued a strategy of selling high-cost reserves to focus on profitability.

"HARD TO FIND." Substituting new international production has been a challenge. Big new fields -- many of them of located in thousands of feet of water -- can take seven years or more to develop. Growth from two of ChevronTexaco's most promising countries, Venezuela and Nigeria, has been hamstrung by OPEC quotas and oil worker strikes. "Oil and gas is hard to find and becoming more expensive," says T. Boone Pickens, the legendary oilman who himself made an unsuccessful run at Unocal 20 years ago. "The really giant fields have been found."

Because of high oil prices, ChevronTexaco has continued to pile up cash. It had $9.3 billion in the bank at yearend, double the amount from 2003.

Unocal has recently seen an uptick in its oil and gas production in large part due to projects such as a giant 4 billion-barrel field in the former Soviet republic in Azerbaijan in which Unocal first invested in the early 1990s. It also holds major reserves in fast-growing East Asia markets such as Indonesia, Bangladesh, and Thailand. Much of that is natural gas that could be exported elsewhere in Asia or to the U.S. A.G. Edwards & Sons oil analyst Bruce Lanni predicts the Unocal deal will help lift its oil and gas growth rate to 6% over the next four years, double the industry average.

"FLAWED NONSTRATEGIC." But this new growth comes at a price. O'Reilly is paying about $9 a barrel for Unocal's 1.7 billion barrels of reserves. ChevronTexaco's historic cost of finding oil is more like $6 a barrel. And the company admits the deal will dilute its stellar return on capital of 26% last year. "We believe the acquisition falls into the grouping of expensive flawed nonstrategic acquisitions that result in dilutions of multiple metrics," wrote Sanford C. Bernstein & Co. oil analyst Neil McMahon in a note to investors.

In his conference call with analysts on Apr. 4, O'Reilly strongly denied that ChevronTexaco is chasing barrels at the expense of profits. "This does not signal a shift," he said. "It signals an opportunity to build for the long term." But so far, the same CEO who wrapped up his investor meeting early isn't wowing anyone with his big acquisition. With bureau reports from London, Caracas, and Hong Kong